The New Oil Cycle

As of yesterday's close on the New York Mercantile Exchange, the price of crude oil has fallen 50% from its July high-water mark. The membership of OPEC must be experiencing an uncomfortable sense of déjà vu, recalling a similar drop between August 1997 and December 1998, when West Texas Intermediate (WTI) bottomed out at $10.72 per barrel, and the OPEC average price fell into single digits. The cost of production is much higher today than in the 1990s, so $10 oil is hardly in prospect, but even an extended period below $50 per barrel would cause severe pain to the oil industry and to anyone investing in alternative energy that competes with oil. However, while a return to $140 oil probably lies on the other side of a global recession, other structural changes could shorten the down-cycle, or at least put a relatively high floor under it, once the customary market overshoot has passed.

Previous oil-price cycles hold some useful insights into the likely bottom of the current cycle, but important differences are also apparent. The 1997-98 collapse was caused by a conjunction of events with strong parallels to today's situation. A wave of new oil projects collided with a sudden drop in global demand triggered by the Asian Financial Crisis. Producers faced a choice between cutting output and bearing unsustainable losses on every barrel sold, but their obvious response was complicated by two serious problems. Operators of mature oil fields employing secondary and tertiary recovery methods knew that once shut in, production might not return to previous levels, later. My former employer, Texaco, saw that happen at its century-old Kern River Field in California. Meanwhile, OPEC's members worried about a long-term loss of market share, similar to what occurred when demand for OPEC's crude fell by 44% between 1979 and 1985, requiring two decades to recover. It took an unprecedented coordination of production cuts between OPEC and Mexico, Russia and Norway--countries that might have otherwise capitalized on OPEC's unilateral cuts--to stabilize the market and nudge prices back into the $20s by mid-1999.

What's different today? Well, for starters, OPEC already has a working relationship with Russia, and the latter's output has stalled, while Norway and Mexico are both in decline. Meanwhile, OPEC has expanded to include Angola, formerly an important source of non-OPEC production growth. If OPEC cuts now, it's hard to see who would step in to steal their market share. The cartel has also enjoyed a better-than-normal degree of cohesion recently--always easier when you are producing essentially flat-out. Key producers such as Venezuela and Iran have seen first-hand the benefits of cutting a little to boost revenue a lot, and their economies depend on prices remaining near $100 per barrel.

Another important change since the late 1990s is the dramatic growth of Canadian oil sands output. The current production of 1.3 million barrels per day now constitutes a large fraction of the world's high-cost marginal supply. More than half of it comes from mining operations that could be slowed or temporarily halted with minimal impact on future output or ultimate reserve recovery. In other words, a drop in crude oil prices below the variable cost of producing synthetic crude from oil sands could be at least partly self-correcting, and fairly quickly.

Biofuels might end up in a similar position. With corn prices back down to around $4 per bushel and ethanol selling for an average of $2.22 per gallon at racks on Wednesday, the "crush spread", or gross margin for producers is around $0.80/gal, similar to where it has been for much of the year. But although ethanol had for most of the year been priced well under Gulf Coast gasoline, the sudden collapse of gas prices has inverted that relationship. With wholesale gasoline--specifically the RBOB mix designed for blending with ethanol--trading on the NYMEX at under $1.70/gal, and the ethanol blenders' credit falling from $0.51/gal to $0.45/gal on January 1, the incentive for refiners to blend more ethanol into gasoline than legally mandated is evaporating.

How quickly these factors could establish a hard floor under oil prices is anyone's guess, and I wouldn't be surprised to see WTI go well below $70/bbl before it corrects. This year's highs might have been helped along by a froth of speculation, but they were also what was required to destroy enough demand to bring a commodity with a low price-elasticity of demand back into balance with supplies that were straining at their near-term limits. That interpretation is also consistent with the dramatic fall in prices accompanying the current collapse of demand. But we can't forget that even if demand in the US and EU continue to shrink, thanks to conservation, efficiency, and alternative energy, the potential demand in Asia remains sufficient to outstrip global oil production capacity, once strong global economic growth resumes. Consumers should enjoy the relief from sub-$3.00 per gallon while it lasts, but they should not assume it will persist beyond the recession.